Analysis of developments in financial markets, economics and public policy geared towards anyone with a stake in these issues......and, yes, we all have one.

Wednesday, August 22, 2012

“Butter is Not a Premium Topping for Bagels” And Other Notes on Inflation.

When glancing at recent
developments in financial markets and economic data releases, a person’s mind
cannot be blamed for drifting towards thoughts of inflation, a phenomenon that
has been a nonissue in post-crisis America, except for us not having enough of it (if this seems paradoxical, keep reading).
After a dramatic drop in prices over the early summer, partly due to a
strengthening dollar, crude oil has risen 22% in recent weeks and is now just
beneath the $100 level. Even more dramatically, corn futures have rocketed 65%,
caused mainly by the historic drought affecting much of America’s farm belt. Given
the ubiquity of these two commodities in daily life, such spikes likely will
cause consumers to pay more attention to prices for any sign of advancement at
the pump or in the supermarket aisle. Not that these fears are unfounded, but
there is a reason why economists prefer to watch core inflation data, which
excludes volatile food and energy products, rather than the all-inclusive
headline number. Over time, many of the fluctuations in volatile food and
energy components tend to moderate and therefore do not lead to broad-based,
sustained inflation.

Last week also saw the release of
July’s consumer price index (CPI), which shows year-on-year headline inflation
continuing to decline after a significant rise in 2011. Core CPI’s rate of
growth dipped as well, to 2.1% over July 2011 levels. This is far from the
deflationary environment many feared would occur as American consumers keep
their credit cards holstered and concentrate on digging out from under massive
debt infamously built up over the past decade. Deflation, defined as
broad-based falling prices, in a highly levered economy could to lead to thinner
profit margins at businesses and even missed interest payments, thus causing a
wave of cost-cutting (i.e. job losses) and corporate defaults. Such a scenario is
a key reason the Federal Reserve has thrown the loose-money kitchen sink at the
problem in the forms of QE1, QE2 and Operation Twist. Predictable and
manageable price increases are a sign of a healthy economy as it translates
into rising corporate revenues, wage increases and possible gains in equity
markets. Bond investors, on the other hand, hate any whiff of inflation.

Sticker Shock

Upon returning to the United
States, I once again took up the tradition of grabbing a bagel before early
morning bike rides. Seven years ago the cost was about 75 cents, toss in another
quarter for butter. On my first visit back to the local bakery, I noticed the
bagel’s price had risen to one dollar. Prices go up, and it had been over half
a decade after all. I could live with that. But at the cash register, I was
shocked to see my total price was $1.60. Butter had risen over two-fold! I was
shocked. Outraged! The cashier rationalized it by saying butter was now
included in the premium topping category, alongside papaya-flavored cream
cheese. What? This is butter! It’s given away freely at every Waffle House and
Denny’s in the country!

Once they restrained me and
management agreed not to press charges, I realized my reaction…although
excessive….was both a common one and also silly. After all, what portion of my budget
do I spend on butter? This leads to key characteristic about inflation: while
food and gas price increases command our attention…and raise our ire…they do
not constitute as much of our consumption as one would think. As seen below, food
only accounts for 14% of the U.S. consumption pie and energy another 10%. In emerging
economies food can comprise up to 50% of a family’s budget, meaning any rise in
(volatile) agricultural goods can have harsh economic and even social consequences.

Revisiting
corn, which is the nation’s number one crop although Colorado’s plethora of
medicinal marijuana dispensaries could cause one to think otherwise, its
largest use is fuel, namely ethanol production thanks to juicy…and probably
unrealistic…government blending mandates for crude refiners.Another major use is feed for livestock. The
40% of the crop being allocated to ethanol along with rising global demand for
protein-based diets putting pressure on remaining corn supplies, in part may
explain why a stupid pat of butter now costs 60 cents at the local bagel joint.
A dairy cow has got to eat after all. This brings up another point. When
consumers purchase commodities products in their rawest form…say an ear of corn
or a gallon of gasoline…increased costs are passed directly onto them. But for
products where these materials are one of many inputs and undergo some form of
processing, such as industrial plastics, transportation costs for retailers or
that oh-so-tasty high-fructose corn syrup, initial price spikes are absorbed by
companies, squeezing profits, and then passed onto consumers only if proven
sustained.

The largest
slice of the CPI pie is reserved for shelter, at 31%, with all-in housing costs
accounting for 41%. Given the still tenuous shape of that sector…even with
signs of life in the rental market…the weight of housing means inflation as measured
by this index may be suspect until the sector rights itself. Another gauge, the
one preferred by the Federal Reserve when deliberating monetary policy, is the
personal consumption expenditure index (PCE), which captures a much broader
array of purchases (with housing at 19% of the total bucket).As seen in the first chart, core PCE has
remained at or below 2%, which is the upper end of the Fed’s unofficial target range, for all of
2011. Despite inflation’s stickiness, many expect the Fed to announce new
easing measures at its Jackson Hole conference next week given its efforts to
achieve the other leg of its duel mandate…maximum
employment…continue to prove woefully inadequate.

If Not From Butter? What Are The
Sources of U.S. Inflation?

In a developed
economy dominated by service industries, a primary source of inflation is
wages. Just as weak housing is partly responsible for keeping a lid on price
hikes, America’s 8.3% unemployment rate also acts as a tamp on upward pricing
pressure.Don’t believe it? Then go ask
your supervisor for a raise and see how quickly it takes for security to show
up at your cubicle with a cardboard box and stopwatch set at 15 minutes.

As seen in the
chart below, PCE has averaged 2.2% growth over the past two decades. Although
energy/gasoline gains accelerated during the commodities boom beginning in the
early 2000s, it still could not outpace the biggest price gainer,
which…surprisingly…is educational services, averaging over 6% per year. Other service-centric sectors also outpaced
overall PCE growth, including healthcare (3.4%) and housing rentals (2.9%). Not
to channel my inner Ron Paul, but as the good doctor has pointed out, healthcare
and education are distorted by substantial government involvement, which
interfere with free market price signals. Housing in the 2000s also fits that
definition thanks to rock-bottom Fed Funds rates and policies aimed at
increasing home ownership. That worked out well. On the flipside, household
durable goods like electronics and appliance have decreased in price over the
decades, along with telecom services. This is great if you want a new XBOX or
cheap wireless data plan, but pretty lousy if you’d like to better yourself
through higher education or undertake a complicated medical procedure.

And the Future Holds…….?

When examining
trends within the sources of inflation, economists and policy makers can
estimate the trajectory of future price increases. But that is easier said than
done, which is why central banks are notorious for being a step slow when
attempting to reel in inflationary pressure often caused by their own post-recession
loose monetary policy. The shadow of the Fed’s premature hawkish moves during
the earlier stages of the Great Depression is a long one.

There is a
range of market-based data that…in normal circumstances…lend insight into
inflation expectations. One such signal is the shape of the U.S. Treasury yield
curve. In the aftermath of the financial crisis, when the Fed pulled out all
the stops to support growth (QE1), analysts predicted that so much easy money
would inevitably lead to rising prices. Consequently, bond investors sold off
longer dated Treasuries, sending their yields higher. With the short-term notes
stapled to the floor thanks to the 0.25% Fed Funds rate, the yield curve
steepened to a record level of over 275 basis points (bps) between the 10-Year
and 2-Year Notes. Ironically, additional Fed policy later that year (QE2),
rather than further steepening the curve on inflationary fears, actually flattened
the curve (squished may be a more appropriate
word) because the Fed itself became the marginal buyer of Treasuries. Looking
at the current 10-2 spread of 150 bps, one could deduce that investors don’t
see any reason to sell off bonds on account of incipient inflation on the
horizon. That would be an erroneous assumption, as the market is distorted by
the Fed’s actions, and Treasuries remain the largest and most liquid
safe-harbor in a world still dealing with the Eurozone fallout and slowing
emerging market growth.

Another
market-based inflation indicator is the inflation-protected TIPS market.
Implied in their yields are inflation expectations for five years out, ten
years out and to get really sexy, the period between years five and ten, in
this case 2017 to 2022. As seen below, implied inflation over the next five
years remains muted at 1.9%. The average for the entire 10-year period,
currently 2.24% is in-line with the past few decades and just north of the
Fed’s comfort zone. However, the final category (2017-2022), shows an implied
rate of 2.6%. In a perfect world that infers that investors with skin in the
game are betting on price levels potentially getting away from central bankers.
But even in the best of times the TIPS market can send out some crazy signals
given its relatively low liquidity compared to mainstream Treasuries.
Furthermore, the whole government bond space has been distorted by the Fed’s
recent measures, thus rendering these market-based measures less reliable than
in the past.

Lastly, despite the soft-jobs market, weak housing and America’s lower
allocation of expenditure towards volatile commodities, inflation can rear its
ugly head. A weakening dollar could solidify materials price gains, causing
them to percolate into the core number. It is this type of commodities-based
inflation that is difficult for central bankers to combat, meaning policy
makers could once-again be shooting themselves in the feet, a la the low rates
which fueled the housing bubble. Consumers, then experiencing sticker shock may
start hording in expectation of even more price increases down the road. They
also may demand higher wages, which, as stated, is a main inflationary force in
a service economy. In that case, inflation becomes a self-fulfilling prophecy. Another
way consumers react when confronted with inflation is to ration demand. When
the pressure is from items not easily curtailed….like eating and enjoying the joyful
daily 90-minute commute to the office….then consumers cut back where they can,
namely on discretionary purchases like movies, apparel or travel. Although that
decreases upward pricing pressure in those buckets, does absolutely no favors
for the purveyors of those products.

For good reason, inflation has been off the radar screens of economists
and consumers alike. But as evidenced by exogenous shocks like the current
drought, and the tendency of monetary (and fiscal) policy to have unintended
consequences, which often take years to germinate, price stability should soon
once again enter into the national economic discussion. Given this point,
perhaps next week’s page will be dedicated to gold investing.

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About Me

During my career as an investment analyst, several developments from the realms of financial markets, economics and public policy struck me as highly relevant, not to me in my role as a market observer, but in my role as a citizen. The subjects covered on these pages are not aimed at fellow investors or policy junkies, but to the broader population, which needs to recognize the shifts occuring in the economy and understand their consequences, as well as those of government policy.